Do sell orders outside the market create “selling pressure”? Regulators seem to think so but empirical research does not support this opinion.
Alec Schmidt, Chief Data Scientist at Kenshõ
Thursday, May 7, 2015
US prosecutors accuse a British trader, Mr. Sarao, of having significantly contributed to the “flash crash” on May 6, 2010. Namely, he placed multiple large orders to sell E-mini S&P 500 futures contracts at prices slightly above the ask price (i.e. outside the market) to create an impression of significant “selling pressure.” The idea is that some naïve investors might decide to sell before the “selling wave” gathered by Mr. Sarao would hit the market. This selling might depress the price, so that Mr. Sarao could buy E-minis at a lower price, which was his true intention. Mr. Sarao then cancelled his sell orders, which constitutes illegal “spoofing”, i.e. submitting orders and then cancelling them to avoid their filling.
But do sell orders placed outside the market really create selling pressure? Let’s start with a simpler question: why do investors submit sell orders outside the market? An opportunistic trader may hope that a large buy order will wipe out inventory at the ask price and fill his order, too. When the inventory at the ask price is replenished, he can buy the asset back at a lower price to balance his book, and make some profit. Is that illegal? I don’t think so. It is certainly risky since inventory at the ask price may be not replenished soon enough. Also, if this opportunity does not materialize for some time, the trader may decide to cancel his order. And then he becomes a “spoofer”…
More importantly, investors often submit sell orders outside the market because they really want to sell but think that the asset they trade is undervalued. When the inventory of sell orders outside the market grows significantly, it may signal that price will go up rather than down. Indeed, traders who keep their sell orders at the ask price and observe growing inventory at higher prices may have second thoughts about why they sell “so low”, cancel their orders and resubmit at higher price. As a result, the ask price grows indeed. My research of the inter-dealer FX market microstructure in 2011 supports this scenario (see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1978977 ).
First, let me introduce two notions: aggregated order imbalance at best price (IBP = inventory at the ask price less inventory at the bid price), and aggregated order imbalance outside the market (IOM = inventory at prices higher than the ask price less inventory at prices lower than the bid price). It turns out that when IBP is notably greater than zero, price most probably goes down. This effect has been described in the market microstructure literature and is explained with that some impatient sellers won’t keep their limit orders in a long queue at the ask price and submit market(able) orders instead, which lowers the price. On the other hand, if IOM is notably greater than zero, price most probably goes up, consistently with the logic outlined in the former paragraph. This effect is very subtle, and it is just an observation in a certain market at a certain time. But it demonstrates that any assumption of trader behavior is vulnerable to contrarian views.